On June 30, 2015, the U.S. Tax Court issued a 92-page opinion on the application of the “investor control” doctrine to a private placement life insurance policy where the policy premiums were used “to purchase investments in startup companies with which (the taxpayer) was intimately familiar and in which he otherwise invested personally and through private-equity funds which he managed” (Webber v. Commissioner, T.C., No. 14336-11, 144 T.C. No. 17, 6/30/15). The taxpayer exercised his control over the policy separate account through a not too elaborate “protocol” in which the taxpayer’s “investment advisor,” accountant and lawyer acted as his intermediaries in the selection, purchase and sale of the investments held in the policy account. This was not a difficult case in that the IRS offered 70,000 (that’s right, 70,000) emails to or from the taxpayer’s investment manager, lawyer, accountant and insurance carrier containing his investment “recommendations”, all of which were followed. Additional evidence also indicated numerous unrecorded telephone calls designed to eliminate any “paper trails”. One should wonder why it took the Tax Court 92 pages to reach what is a clear-cut case of investor control.
The Tax Court’s analysis begins with an acknowledgement that a private placement variable life insurance policy offers tax deferral on a separate account’s “inside buildup” as it is earned as well as favorable tax benefits in the event of the death of an insured (which in this case were elderly relatives of the taxpayers). In confirming these tax benefits, the Court did not draw any distinction between private placement policies and conventional policies backed by general account assets. Moreover, the Court was not troubled by the fact that the carrier reinsured nearly all of the mortality risk to a third party reinsurer (the carrier only retained $10,000 of the risk on a $2.7 million policy). These benefits only exist, however, where the “insurance company owns the investment assets in the separate account.”
The “investor control” doctrine determines, from a tax point of view, whether the insurance company or the policy owner owns the investment assets of the policy. To determine “ownership” the Tax Court traced the roots of the investor control doctrine to the early days of the Federal Income Tax where several landmark cases, such as Clifford v. Helvering, 281 US 331 (1940), held that income is taxed to the person who has “dominion and control” over an investment.
The Tax Court confirms deference to the Service’s interpretation of these principles in the context of insurance company assets as embodied in several Revenue Rulings, e.g., Revenue Ruling 77-85, 1977-1 C.B. 12. This is important in that, apart from a series of infrequent Revenue Rulings and an occasional court case (e.g., Casperson), application of the investor control doctrine will depend on the lines drawn in this case.
The Court highlighted three principles in determining whether a policyholder rather than the insurance carrier is the owner of investment assets, namely, (1) who has the power to select investment assets by directing the purchase, sale, and exchange of particular securities, (2) who has the power to vote the securities or exercise rights pertaining to the securities and (3) who has the power to extract money from the account by a withdrawal or by other means. A few thoughts on each:
Selection of assets
In this case the policyholder had complete control over the selection purchase and sale of these particular assets. The investment “protocol” established by the policy holder’s advisors was no more than a device to imbue otherwise unrelated parties with the color of independence when in fact they acted solely on his instructions. This arrangement was purely cosmetic and differs in all respects from cases where an investment advisor of a separate account or manager of an insurance dedicated fund act independently. The Court will not rely solely on the terms of an insurance policy that require separation between the policy holder and the investment process, but will instead look to whether the process is directly or indirectly controlled by the policy holder.
Like the selection of investments, voting and other decision making in respect of the ownership of assets must be in the hands of the insurance company. This principle also applies to the exercise of rights such as reinvestments, options and tag-along provisions pertaining to specific securities. A related issue currently arises where policy investments may carry the right to serve on an investment committee or advisory committee. It seems clear that such positions should not be held by policy holders.
The facts in Webber were peculiar in that the policy limited the right to withdraw funds from the policy to the amount of premium contributed by the policy holder. The taxpayer argued that he should not be taxed on any gain in the policy because he could not access that gain through a surrender or policy loan. This may well have been a successful argument had the policy holder not accessed the assets of the policy in other ways. In particular, the policy assets were made available in several other ways, including the use of policy funds to purchase assets from the holder, to purchase assets for his personal use (a vineyard and a resort property), and to act as a co-investor in projects in which he sought to invest personally.
The withdrawal of funds from a policy is not unusual nor should it be fatal where access is treated as a policy loan or partial or full surrender. If this were not the case, all insurance policies would fail the investor control test. Rather, investor control becomes an issue where something that cannot be done directly, such as taking a policy loan, is done indirectly, such as purchasing an asset for the policyholder’s personal use. The policing of this issue fairly falls on the insurance company as well as the taxpayer and strong policy language alone will not be sufficient to avoid protecting the integrity of a policy.
A final point on this case. As noted above, the policy holder argued that the limitation on his right to only withdraw the amount of premium paid on the policy meant that taxation should be limited under Code section 7702(g), which limits taxation to the increase in a policy’s cash value available to the policy holder. The Court easily dismissed this argument by pointing out that section 7702(g) only applies to policies that fail the definition of life insurance under section 7702(a). Since the policy’s risk corridor complied with section 7702(a); section 7702(g) did not apply. More importantly, the Court pointed out that the investor control doctrine overrides section 7702(g) so that even if it did apply the policy owner would nonetheless be taxed on the earnings of the separate account assets. The policy holder made several other technical arguments as to the inapplicability of the investor control doctrine. The dismissal of those arguments and the affirmation of the overriding principles governing the doctrine are very important at a time when private placement insurance is playing a greater role in private wealth planning.
It is important to note that the facts in Webber involved a policy issued over 15 years ago, when the investor control boundaries were not as developed as they are now. The kind of investor control exercised in that case is not characteristic of policies issued by leading insurance companies in today’s market. Few insurance companies will accept or invest in private equity assets connected with a policy holder and most insurance company platforms is limited to independent insurance dedicated funds and institutional investment managers. Nonetheless, the restating of the rules of the road at this point in time aids the careful and deters the reckless.
About Perry Lerner
Chairman & CEO
Perry Lerner is the co-founder of Crown Global and is focused on the company’s strategic planning, product development and institutional relationships.
Prior to founding Crown Global, Mr. Lerner was a managing director of CPW Capital, LLC and Crown Capital Group, LLC, private equity investment firms. He was also one of the founding members of Fresh Direct, LLC. Before that, Mr. Lerner was a leading tax partner at O’Melveny & Myers LP in New York, London and Los Angeles. He is a member of STEP and has many years of experience advising high net worth families and businesses on international tax planning matters. Mr. Lerner also worked as attorney advisor in the Office of International Tax Counsel of the U.S. Treasury Department.
Mr. Lerner is a member of the Board of Visitors and Governors of St. Johns College (Annapolis and Santa Fe); Board of Trustees Claremont McKenna College, and Director of Boss Holdings, Inc. Mr. Lerner received his Bachelor of Arts degree from Claremont McKenna College and his JD from Harvard Law School.
About Crown Global
Crown Global provides efficient investment-enhancement strategies and products for institutional investors, investment managers and ultra-high net worth individuals. The Company offers custom solutions that enable managers and investors to enhance their returns from investments in alternative assets and managed accounts. Crown Global operates globally and maintains offices in North America, Switzerland and the Cayman Islands. Since its founding in 1998, Crown Global has established a solid track record of issuing U.S. and non U.S. compliant life insurance and annuity policies for institutional and ultra-high net worth clients. Learn more at http://www.crownglobalinsurance.com.